Can Technology Stocks Maintain Their Strength?

September 8, 2009

Portfolio Managers Ken Allen and David Eiswert take a look back at how the technology sector fared in the first half of the year and offer an outlook for the future.

Technology stocks posted solid gains in the first half of 2009 and handily outpaced the broader market despite a weak economy. Even when the market fell to multiyear lows in March, technology stocks proved to be resilient for two primary reasons. The following discusses those reasons and provides insight on the technology sector overall.

In early 2009, companies had aggressively reduced costs to protect earnings and cash flow, and the credit crisis shed positive light on their cash-rich balance sheets. In addition, tech stocks—reflecting investors’ skepticism about their strength in light of the tech bubble bursting earlier this decade—carried relatively low valuations.

Signs of economic stabilization and better-than-expected technology spending are likely to sustain the group even though spending on technology products and services is expected to remain weak. According to Ken Allen, portfolio manager of the T. Rowe Price Science & Technology Fund,“We believe that in an eventual economic recovery, revenues will improve markedly. With better revenue, earnings improvement should be even greater given that many technology companies’ business models have considerable margin leverage.”

David Eiswert, portfolio manager of the T. Rowe Price Global Technology Fund, says, “The combination of low valuations, tightening capacity utilization, a natural recovery in the supply chain, and unprecedented global and monetary stimulus creates conditions that are ripe for solid performance from global technology stocks.”

The expected weak recovery means that economic challenges will remain significant, but we believe the underlying health of the technology sector is generally sound.

• Technology companies have strong balance sheets and attractive business models.
• Earlier cost-cutting efforts provide earnings protection in a low-revenue environment.
• Industry consolidation is likely to accelerate as large, cash-rich companies target smaller ones with valuable products and customer bases.
• Technology advancement continues in the form of smartphones and new applications of online advertising and commerce.

The unknown, according to both managers, is when consumer and business spending on technology will return to normal levels. Shipments of nondefense capital goods (including technology) are at 2004 levels, and there have been few signs of any pickup. Consumer spending has recovered only a part of its decline, back from its depths earlier in the year and about where it was a year ago. Many forecasts are that consumer and business spending will remain sluggish well into 2010.

“Although significant uncertainties and challenges remain, we believe the global economy avoided a worst-case scenario, and the receding fears have created a generally hospitable environment for technology stock performance,” says Eiswert.

Technology stocks historically have experienced unusually wide price swings, both up and down. The potential for wide variation in performance reflects the special risks common to companies in the rapidly changing field of technology. Investing internationally could be affected by declining local currencies or adverse political or economic events.